Ecuador's Debt Default: Exposing a Gap in the Global Financial Architecture

When the
government of Ecuador failed to make a scheduled interest payment on
private bonds today, it was hardly the first time a country had
defaulted in the middle of a financial crisis. In fact, it wasn't even
the first time for Ecuador. The small South American country did so
just 10 years ago, at a time when the economy was reeling from natural
disasters and a drop in oil prices.

But this default is different. For the first time in history, the
government's defense isn't based on an inability to pay. Ecuadorian
President Rafael Correa explained rather that he was unwilling to continue to pay debts that are "obviously immoral and illegitimate."

Like many of the victims of the U.S. subprime mortgage mess, the
Ecuadorian people were the targets of predatory lending. In the 1970s,
unscrupulous international lenders facilitated some $3 billion in
borrowing by Ecuadorian dictators who blew most of the money on the
military. After the transition to democracy, the Ecuadorian people got
stuck holding the bag.

Over the years, the country has made debt payments that exceed the
value of the principal it borrowed, plus significant interest and
penalties. But after multiple reschedulings, conversions, and some
further borrowing, Ecuador's debt has risen to more than $10 billion
today.

Human Costs

The human costs are staggering. Every dollar sent to international
creditors means one dollar less is available for fighting poverty. And
in 2007, the Ecuadorian government paid $1.75 billion in debt service,
more than it spent on health care, social services, the environment,
and housing and urban development combined.

Correa campaigned on a commitment to prioritize the payment of the
"social debt" over financial debt. After taking office in 2007, he
responded to demands from Ecuadorian civil society and the
international Jubilee Network to form an independent commission to
investigate the origins, nature, and impacts of the nation's external
debt. While citizens' groups in other countries have carried out their
own debt audits, this was the first time a government had supported
such an effort.

The debt audit commission documented hundreds of allegations of
irregularity, illegality, and illegitimacy in the contraction of
Ecuador's debt. In the case of the bonds Ecuador has now defaulted on,
the commission alleged that they were issued and restructured
illegally, violating Ecuador's domestic laws, U.S. Securities and
Exchange Commission regulations, and general principles of
international law. The agreement that gave rise to the Global bonds
themselves may not be legal under Ecuador's constitution, which
prohibits an individual from incurring debt on behalf of the country.

Commercial debt is the most expensive component of Ecuador's
portfolio, making up only 30% of its total obligations but comprising
44% of the country's interest payments in 2007.

Correa says he hopes to cut a deal with creditors, much in the way
that many U.S. homeowners are seeking to restructure their subprime
mortgages. Ecuador's global bonds are currently valued at $3.8 billion.
If negotiations aren't fruitful, however, the economic repercussions
could be severe.

One avenue for the bondholders would be to sue under the
U.S.-Ecuador bilateral investment treaty, which went into force in 1997
(long before Correa took office). Arbitration tribunals, such as the
World Bank-affiliated International Centre for the Settlement of
Investment Disputes (ICSID), handle such cases. Under this system,
there is no public accountability, no standard judicial ethics rules,
and no appeals process. A group of Italian investors has a pending
ICSID claim over about $5.5 billion in bonds that Argentina defaulted
on in 2002.

Investors could also sue in New York courts, as the bonds were
issued under the laws of that state. Holders of Argentine bonds have
also used that tactic.

Financial analysts have also predicted that Ecuador's default will
cut off the country's access to capital markets and could dim its
chances of obtaining a long-term extension of U.S. trade preferences,
which will expire in 2008.

While the risks of default are high, Ecuador had only two options:
keep paying a dubious and possibly illegal debt at the risk of social
unrest, or default and face the wrath of the international markets.

Independent Mechanism

This exposes a gaping hole in the international financial system:
the lack of an international, independent mechanism for countries to
resolve disputes over potentially illegitimate and/or illegal debt or
in the case of bankruptcy. Ecuador may be the first developing country
to default during the current crisis, but it's unlikely to be the last.

As world leaders seek to build a new international financial
architecture to respond to the current meltdown and prevent future
crises, they should consider a new debt workout mechanism as one key
pillar.

A bill pending in the U.S. Congress would be a step forward. The
Jubilee Act, which passed the House of Representatives in 2008, would
require the Comptroller General to undertake audits of the debt
portfolios of previous regimes where there is substantial evidence of
odious, onerous, or illegal loans. The legislation also instructs the
Secretary of the Treasury to "seek the international adoption of a
binding legal framework on new lending that...provides for decisions on
irresponsible lending to be made by an entity independent from the
creditors; and enables fair opportunities for the people of the
affected country to be heard."

To ensure more responsible and productive lending and borrowing in
the future, we need to learn from and redress the errors of the past.
Only then can we build the architecture for an international financial
system that works for people and the planet.